When Reserve Bank of Australia governor
Glenn Stevens
caught up with United States Federal Reserve chairman
Ben Bernanke
in Washington last month, he was surely tempted to drop in a few home truths as they discussed the world economy.

Stevens may be the most powerful economist in Australia, but to a certain extent, even on home shores he is playing second fiddle to Bernanke’s extraordinary easy money policies. The Reserve Bank has lost control of its own destiny, unable to curtail the soaring Australian dollar.

Despite lowering interest rates by more than 2 percentage points since November 2011, the dollar has remained stubbornly high, even as commodity prices have fallen. Its strength has become a real problem.

The major driver of the high Aussie dollar is Bernanke’s $US85 billion monthly stimulus, an attempt to revive the US economy. Money printing in the US is maintaining upward pressure on the Australian currency as global investors seek a better than zero yield, says Triple T Consulting credit analyst
Sean Keane
.

“The Fed’s policy response to its domestic problems has seen it successfully export part of its challenge to the desks of foreign central bankers, forcing them to ease domestic policies in what became a globally synchronised policy easing, regardless of local conditions," Keane says.

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The local economy is struggling to cope with a dollar that has been oscillating between US94¢ and US97¢ in recent weeks.

Stevens made it abundantly clear this week that he has become increasingly frustrated by the high dollar, even trying to talk the currency down and suggesting that the US tapering its bond-buying would be good for the world. But unless foreign exchange traders are listening, the Reserve Bank will remain beholden to the Fed’s actions.

Stephen Oliner
, an economist who worked at the US Fed for 25 years, says the external spillover effects of the Fed’s extraordinary measures will not really bother the world’s most important central bank.

“The question for the Reserve Bank of Australia and other countries is ‘what do you do about it?," Oliner says. “You can run a relatively loose monetary policy but then you have to ask if there are other tools available to try to dampen what you think might be an emerging real-estate bubble."

Herein lies the dilemma facing Stevens and his board. It has already dropped the cash rate to an historic low of 2.5 per cent to try to stimulate lethargic domestic economic activity and in the hope it may take some pressure off the high exchange rate.

But to date, the real economy has largely failed to respond. A lift in consumer and business confidence, rising wealth from higher asset prices and tepid signs of more new homes being built have so far failed to translate into materially better overall economic activity.

While the economy muddles through at sub-par growth, record low interest rates are causing property prices to surge, prompting talk of a risky bubble. Capital city house prices continue to hit record highs and auction clearance rates of more than 80 per cent show buyer demand is almost insatiable.

“It’s not just surging house prices, it’s surging asset prices if you look at the ­stockmarket," eminent economist
Warwick ­McKibbin
says. The Australian sharemarket is tracking at about a five-year high, as investors switch out of low-yielding cash and into higher risk equities. The paradox of surging asset prices in a weakening economy is a recipe for a potential future economic disaster.

Beginnings of a property bubble

The International Monetary Fund estimates that Australia’s cash rate is about 0.5 of a percentage point lower than the rate the Reserve Bank has historically employed for the equivalent economic conditions.

The combination of low rates, strong demand for property from overseas buyers – especially the Chinese – and rules making it easier for self-managed superannuation funds to invest in property, are pumping up house prices.

National home prices are up about 8 per cent over the past 12 months and are more than 11 per cent higher in Sydney, where the median house price has hit $722,000, according to Australian Property Monitors.

Still, property booms in Australia are not unusual, particularly during the last 20 years of unbroken economic growth.

The difference between this boom and last time, as AFR Weekend’s columnist ­Christopher Joye has highlighted, is that household incomes are growing much slower at about half the rate. In the early to mid-2000s when there was strong property price growth in most capital cities, disposable income grew at about 6 per cent a year.

Now, with softer economic growth and cost-conscious employers trying to keep a lid on expenditure, incomes are growing at about 3 per cent, approximately the rate of inflation. As a result household leverage is edging back up.

The household debt-to-income ratio of 148 per cent is just below its peak of 153 per cent. House prices relative to income are also nearing their historic peak.

The low rates and hot housing market have prompted warnings that Australia risks following the mistakes of the Fed when it anchored its funds rate at 1 per cent in the early 2000s.

McKibbin says Australia must heed the lessons of the US experience.

US housing prices rose strongly from 2001 to 2006, but fell by between 20 per cent and 30 per cent in many US cities when the housing boom went bust from 2007 to 2010.

Fed chairman
Alan Greenspan
’s low rates undoubtedly contributed to the housing bubble. Yet there were other factors at play, which gives Australia reason to think that the parallels with the US are perhaps not so accurate.

First, US government policy actively encouraged lending to people who could not afford to buy a home.

Second, US banks dramatically lowered their lending standards by making riskier loans to less credit-worthy people. Australian regulators and banks insist local lending standards generally remain prudent. Time will tell if that turns out to be true.

Third, credit growth was excessive in the US, running in double-digit figures leading up to the crash as households became more and more leveraged.

Economies not apples and oranges

In Australia, as governor Stevens pointed out in his speech on Tuesday, credit growth remains subdued. Over the year to September, housing credit rose by 4.8 per cent.

Furthermore, US housing prices were already rising strongly before the funds rate was dropped to 1 per cent in 2003. And about three-quarters of home loans had 30-year fixed rates, suggesting the Fed’s low funds rate was not the only factor driving up demand for homes.

In Australia, Stevens this week talked down the idea there was a risky bubble, ­stating that a rise in house prices is a natural part of the economic cycle and will improve incentives to build much-needed new homes.

But he warned of the recent increase in investor activity in Sydney (up 40 per cent over the past year) and the need for both lenders and borrowers to make “decisions . . . based on sensible assumptions about future returns."

There is a powerful argument that the Reserve Bank cannot leave rates low and continue to allow property prices to appreciate, especially as the economy is forecast to grow at a sub-trend rate and unemployment is tipped to rise above 6 per cent as the mining investment booms winds down.

This is the excruciating conundrum facing Stevens and his board who will meet next Tuesday to deliberate over monetary policy.

Oliner suggests there may be better options than low interest rates to stoke the economy and avoid a risky asset bubble.

New Zealand is going through a similar dilemma and has employed so-called ­“macroprudential tools" by imposing “speed limits" on the proportion of new high loan-to-valuation ratio lending that banks are able to do. It has already led some banks to withdraw what had been pre-approved mortgage offers to some house buyers.

The better option, McKibbin argues, is a larger role for fiscal policy to support ­economic growth through investment in productive infrastructure.

“I don’t think you can fix the mining investment adjustment and structural adjustment in this economy using monetary policy," McKibbin says.

“Monetary policy really just moves spending from the future to the present, or from the present to the future."

He argues there also needs to be microeconomic reform to increase flexibility in the labour market, cut green and red tape and to lower costs across the economy and deal with the stubbornly high currency.

Both these ideas have merit and there are signs Treasurer
Joe Hockey
sees infrastructure projects as an important tool to support the economy as the mining investment boom retreats.

Reserve Bank deputy governor
Phil Lowe
said last week that mining investment relative to gross domestic product may decline by 3 percentage points or more over coming years. Still, the Reserve Bank would be mindful that there are typically delays in infrastructure projects being built in a timely enough manner to support an economy in the doldrums.

Can we afford to wait?

For now at least, the Reserve Bank is counting on the Fed unwinding its huge stimulus sometime in the next few months.

The consensus among American economists is for the Fed to begin the taper in March, coincidentally when
Janet Yellen
is due to take over as the new Fed chair.

Conventional economic wisdom suggests if the Fed pulls back on the bond-buying, then long-term US interest rates will rise.

This would likely help ease global demand for yield assets in Australia and take pressure off the currency. That assumes the US doesn’t enter another fiscal crisis in the new year, which McKibbin warns would cause Australia to become even more of a safe haven and increase demand for Aussie-denominated assets.

The mild-mannered Stevens will be hoping Bernanke starts the unwind sooner and the fiscal debate is sorted to give the Reserve Bank back some of its authority at home.